*Now is the time for a thorough review of regulation and competition in the water sector, Ofwat chief executive Regina Finn tells Janet Wood.*

When water regulator Ofwat produced its draft determination water companies' spending and revenue plans for the next asset management plan period, 2010-15, it was accused of abandoning the long-term approach the industry had been building. Today, when all but one water company has agreed the determination, chief executive Regina Finn insists nothing could be further from the truth.

She says: "We have had the 25-year strategic direction statements, which we asked companies to do, and we asked them to set their plans within them. We have started for the first time to quantify the companies' carbon impact - that was never done before. The embedded cost of carbon begins to be taken into account in cost decisions and that's a long-term issue, not a short-term issue.

*Long term funding*

"We have approved more than 100 catchment management schemes in this price round. They are not things that will deliver in five years. We have approved a significant amount of funding for drainage and surface water.

"We have already started to embed a lot of those long-term issues in this price round and we have approved a significant number of new tariff trials to try to understand how we can better help customers through tariffs. When you put that together, that's the proof that we are taking a longer term view within the framework we have."

She is equally bullish about suggestions that the recession meant the regulator cut plans too much, to keep prices low. She says: "Clearly we look at the broader economic situation because the sector operates within that. We were lucky, in that within the two-year period where we were working on this we saw the recession coming in, we saw it getting very difficult and we saw the beginning of recovery, particularly in the capital markets.

"We maintained a stable and steady position throughout. It is important that we get the balance right: sustainable financially, so the companies can make some money to invest; sustainable socially, so customers are willing to and able to pay their bills ... and sustainable environmentally."

*Adapting for the future*

The recession is passing, she says, but the industry has other issues to deal with. Now is the time to reconsider the fundamental framework. Finn explains: "I think now we are looking at a much bigger question, which is about how the entire regulatory framework evolves and adapts for the longer term. We have a window of opportunity to do that because we have a stable period of operation now."

That means preparing for some big changes in the operating environment. "What we know is that the challenges are more uncertain than in the past," she says. "There's the chance of climate change, there's population growth, there's the question of water resources - where it comes from, how we capture it, how we collect it. When you are facing more uncertain challenges, you need to come up with a more flexible way of tackling them. It is unrealistic to think that a 20-year-old framework is flexible enough to cope with those new challenges."

She says it is not about tweaking the existing framework: the industry needs a root and branch review. "That includes asking questions about the environmental side of this business - how we make sure the environment is factored in," she says. "We must ask questions about the social side, and how we ensure the economic and financial sustainability of the sector and make sure that the sort of investment we will need continues."

*Root and branch review*

That root and branch review starts on 3 March with a meeting open to anyone with an interest in the industry and its future. At that meeting, "we will set out the big themes, how we intend to work on them and how we will engage with stakeholders".

The themes encompass most of the industry's activities. Listing some of the likely workstreams, Finn includes: "How the regulator sets price limits next time around, which includes the duration, and whether we have one price limit for every company or we have more than that. There are issues around metering and charging: what is the role of metering in this sector in the long run and what are the synergies with the energy sector. Is there is a link - there clearly is - between water, energy and carbon?"

She says Ofwat is still working on how to manage the review: "There are big questions there and we need to make these workstreams into manageable packages that people can work with us on. We want to use that engagement to develop proposals."

*PR14*

Although we have just completed one price review, companies will soon be preparing for the next. Can such a comprehensive review move fast enough to give companies visibility of what to expect for PR14? Finn is conscious of that time pressure. "It may seem like a long time until we set prices again, but it's not," she says. "What we need is a road map for where we should be going, within 18 months to two years."

As well as the regulatory framework, Ofwat will be looking at competition. For Finn, the two are inseparable. She points out that Ofwat is a competition authority as well. "My job is to get the best result," she says. "Sometimes that comes through markets and sometimes through regulation. You have to use the tools together, and that's the way we are running our fundamental review of our functions."

*A value for water*

She is clear that the market has a role to play, especially on one fundamental issue: establishing a value for water. "For us to make these sustainable decisions in the longer term we need to start to understand value, and market forces have a strong role to play in that. We saw the Cave Review mention abstraction trading and we need to know where water is more valuable, less valuable or scarcer, so it helps us make the right investment decisions."

She stresses that exploring this area will not delay other aspects of the review. "There is lots in the Walker report about tariffs and how we help vulnerable customers. There is a lot we can do around the issue of real competition and choice for business customers ... There is a lot about how we will set future price limits - the mechanism, the duration. We can do all that and in parallel do the work on understanding the value of water."

Finn is also keen to get more visibility of the value chain, by extending work that has already started on accounting separation within water companies. She says: "I think that is the first step throughout all the work we are doing. The sector has delivered a lot in the past and it has delivered it through the vertically integrated monopoly companies, but they are black boxes in terms of information. That's fine, that's the way it's been, but now we need to unpick that information to understand better the benefits and the costs of any decisions we might make."

*New entrants*

I suggest that these changes could fundamentally alter the nature of companies in the sector, and bring new ones in. Finn sees signs of that happening: "There are lots of opportunities already, particularly in the less talked-about side of the business. There is competition in industrial trade effluent, for example. There are new appointees who are coming in to provide complete services for businesses and for housing estates and that changes the dynamic. Then there is a provision in the Floods and Water Management Bill for tendering and outsourcing large projects. There are lots of opportunities."

However, Finn says that these changes cannot come by way of a diktat from Ofwat. "Saying we know the answer, and it's designed like, this is bound not to deliver the best results," she says. "They are delivered if we free up and allow the sector - customers as well as companies - to make choices."

*Last days of economic regulation?*

It has been suggested recently that there may have to be fundamental changes in the regulator as well, and there should be an end to pure economic regulation. Finn denies that her view is narrow: "We have a broader remit than purely financial regulation. Economic regulation encompasses environmental and social issues as well. That's quite holistic, compared with being just about prices. We are about much more than that and our duties are quite broad - about balancing social, economic and environmental issues."

Nevertheless, she says, the review will also examine Ofwat's role in the sector, and it may well need to be reconsidered. "We may find that we need some different tools to regulate more flexibly in the long term because the system is fairly rigid, frankly, and it has been for 20 years.

"Our initial view is that our high level duties are fairly well balanced and broad enough to allow us to take all the necessary things into consideration. But in the legislation the more detailed tools that we have are probably not flexible enough and we are doing some self-analysis on that."